Yes, Virginia, There Can Be a Free Market for Health Care

One of the big divides between liberals and conservatives, of course, is on the value and utility of the free market. Most Americans appreciate that market-based economies, broadly speaking, outperform state-based ones. But most, if not all, progressives make the argument that health care is different: that markets may work for computers and soda pop, but they don’t work in health care.

The most famous exposition of this theory that markets can’t work in health care comes from Stanford economist Ken Arrow. In 1963, the Ford Foundation approached Arrow—an up-and-coming economist, albeit one without prior health-care experience—about applying his theories to the practical problems of health, education, and welfare. With Ford’s support, in December of that year, Arrow published a paper in the American Economic Review entitled “Uncertainty and the Welfare Economics of Medical Care.”

In it, Arrow endorsed the view that “the laissez-faire solution for medicine is intolerable,” that the delivery of health care deviates in fundamental ways from a classical free market, and therefore, that government must intervene to correct these deviations.

Arrow’s paper energized those who were already predisposed to skepticism about free markets. Indeed, many people credit Arrow with inventing the field of health economics. Arrow went on to share the Nobel Memorial Prize in Economics in 1972: the youngest person to ever garner that honor, although it was for his work outside of health care.

With characteristic understatement, Paul Krugman wrote in 2009, “Economists have known for 45 years—ever since Kenneth Arrow’s seminal paper—that the standard competitive market model just doesn’t work for health care…To act all wide-eyed and innocent about these problems at this late date is either remarkably ignorant or simply disingenuous.”

Unpredictability. Arrow points out that people’s needs for health care are unpredictable, unlike other basic expenses like food and clothing. But while we can skip the occasional meal or sale at Old Navy, our need for health care can be far more urgently necessary.

Barriers to entry. Arrow notes that you can’t just set up shop on the side of a road and practice medicine: you must have a license to be a physician, and gaining that license requires years of expensive schooling and training. As a result of this constraint on the supply of physicians, there is a constraint on the supply of medical services.

The importance of trust. Trust is a key component of the doctor-patient relationship; if a surgeon makes a serious mistake during an operation, for example, the patient may die or become permanently disabled. The patient must trust that the surgeon knows what he’s doing, and can’t test-drive the surgery beforehand.

Asymmetrical information. Doctors usually know far more about medicine than do their patients. Therefore, the consumer of medical services (the patient) is at a serious disadvantage relative to the seller (the doctor). Patients are therefore vulnerable to exploitation. In addition, third-party payors of medical bills, such as insurers or the government, are that much more removed from the particulars of a given case, and unable to effectively supervise medical practice.

Idiosyncrasies of payment. Unusually, patients pay for health care after, not before, it is received (that is, if they pay for health care at all). Because patients don’t see the bill until after the non-refundable service has been consumed, and because patients are given little information about price and cost, patients and payors are rarely able to shop around for a medical service based on price and value. Compounding this problem is the fact that patients rarely pay for their care directly.

Arrow wasn’t wrong to point out these distortions. Where Arrow goes wrong is in contending that these distortions are unusual, or unique to health care. Indeed, Arrow’s prescriptions for addressing health care’s distorted market involve…further distortion.

Arrow's antique critique

From today’s perspective, Arrow’s commentary comes across as a bit antique. Let’s go through his objections.

Unpredictability is hardly unique to health care. Indeed, in the five decades since 1963, an entire industry has emerged to address the problem of unpredictability. Think of the extended warranties you’re offered when you buy a new television, in case the product stops working. If you worry about being suddenly short of money, or accidentally making a mistake with your checking account, you can buy overdraft protection. If you’re afraid of flying, you can buy traveler’s insurance. And I haven’t even brought up the classical forms of insurance, such as homeowner’s insurance, auto insurance, and life insurance.

It’s true that we have instituted barriers to entry in the delivery of medical care: a problem that Paul Starr documents well in his definitive history of the subject, The Social Transformation of American Medicine. But again, this is hardly a problem that is unique to medicine. It’s a lot easier to get a medical degree than it is to start an airline or a bank from scratch. We require licensure of lawyers, but Ken Arrow never managed to write a paper advocating for the nationalization of the legal industry. And it’s not just doctors and lawyers: in many parts of America, you need a license to become a cat groomer, tattoo artist, or a tree trimmer.

Trust is certainly important in medicine. But trust is also important in many, if not most, commercial transactions. We trust that the manufacturers of car brakes have thoroughly vetted their products. We trust that cruise ship captains are sober when they’re on duty. And if we feel our trust has been violated, we trust properly-licensed lawyers to sue on our behalf.

As any Megan McArdle fan knows, asymmetries of information are everywhere. The ancient Latin aphorism, caveat emptor (“let the buyer beware”), has been enshrined in property law for centuries. The idea is that sellers know more about the defects of what they are selling than do buyers. Hence, traditionally, we hold buyers responsible for understanding what they are buying, so long as the sellers haven’t engaged in fraudulent misrepresentation. We accept that auto mechanics know more about our car’s problems than we do, and we take our business elsewhere if we feel like they’ve been ripping us off.

When it comes to medicine, the internet has made great strides in reducing asymmetries of information. A parent of a child with a genetic disorder, or Lyme disease, is likely to know as much, if not more, about available treatments than will your garden-variety family practitioner. Patient forums and websites like WebMD give people access to medical knowledge in a way that they didn’t have it before.

The last of Arrow’s concerns is the most important: that we pay for medical services in a non-standard way, especially through third parties. Free-marketeers have long sought to remedy this problem. On the other hand, Arrow’s proposed solution to third-party payment—government-sponsored insurance—makes the problem worse, by further removing patients from the price and value of the care they receive.

Can we shop for health care?

Today’s progressives add a few more bullet points to Arrow’s critique.

Some say that health care is a uniquely emotional decision. I might shop for a laptop based on the speed of its microprocessor and the resolution of its screen, but if I get cancer, I’m going to want the best possible care, with price as no object.

But we make many purchases on an emotional basis. I occasionally take a date out to a nice restaurant, instead of buying her a sandwich at the grocery store, and not because the restaurant’s food has superior nutritional content. Entire industries—jewelry, say, or Hollywood—exist for no other reason than to satisfy our emotional interests.

My point here is not to say that health care is the same thing as jewelry: but rather that health care’s emotional component is not economically unique.

Others point out that you can’t always shop for health care. If you have a heart attack and become unconscious, you aren’t capable of deciding where to get treated. This is probably one of the most important ways in which health care can differ from other economies.

So let’s stipulate that this is true. No, you can’t shop for health care when you’re unconscious, or when you’re in acute or emergent situations. Does this justify nationalizing the health care system?

No. At most, it justifies nationalizing a subset of health-care decisions that take place in acute settings. For example: I am certainly capable of shopping around to find a reputable doctor that will offer me a routine prostate exam at a reasonable price. I’m even capable of shopping around for care for chronic conditions, like diabetes or end-stage kidney disease. I’m less capable of shopping around if I have a stroke (though I am capable of shopping for an insurance plan that will try to help me get cost-effective treatment).

Of the $2.6 trillion Americans spent on health care in 2010, according to the Centers for Medicare and Medicaid Services, $814 billion—31 percent—was for hospital care. And not all hospital care is acute. So, the inability to shop for care applies to less than three-tenths of all health spending.

So, it seems to me, those who strongly believe in the shopping argument for socialized medicine should adopt a hybrid approach. Let’s have a free market for the 70-plus percent of health care where market forces can most directly apply, and let’s have universal catastrophic insurance for those situations where market forces work less well.

In such a situation, we might get the best of both worlds: an efficient, affordable, high-quality market for chronic and routine health care, and a universal system for those who get hit by a bus, or have a stroke, or get cancer. Such a system would leave no one behind. But it would also allow our health-care system to benefit, as much as possible, from the forces of choice, competition, and innovation.